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How defensive are ‘defensives’?

Maybe it’s time to redefine what is classed as a defensive equity, says Anthony Rayner, manager of Miton’s multi-asset fund range

Conventional wisdom suggests ‘defensive’ equities are typically found within the utilities, pharmaceuticals, telecoms and consumer staples sectors. Logic has it that the demand growth for products and services of companies within these sectors, due to their nature, is fairly consistent and, therefore, so is their profit growth. By extension, they are considered less sensitive to the economic cycle than say, the mining, banking or consumer discretionary sectors.

Defensive sectors are also referred to as bond-proxies, in part due to these perceived safe-haven characteristics but, also, as they have generally offered decent yields too. Indeed, post global financial crisis history saw defensive sectors rally sharply, due to recessionary concerns lingering, but also as a result of the powerful QE-driven rally in bond markets. Until early 2016 that is.

As economic growth momentum started to build in H1 2016, investors duly rotated from defensives to cyclicals, with cyclicals outperforming pretty consistently until the beginning of this year. The graph below shows how cyclicals have outperformed defensives over the last twelve months (though the evidence during 2018 is more ambiguous). At first sight, it’s perhaps surprising that defensive sectors provided no discernible protection vs cyclicals during the 10% fall in the S&P 500 Index, highlighted below.

How defensive are “defensives”?

Source: Bloomberg, 01/05/2017 – 30/04/2018.

On closer inspection though, we think it makes sense. Firstly, the correction wasn’t driven by recessionary fears. Additionally, and this is something we talk about a lot, the risk characteristics of asset classes aren’t a static concept. Just as we are doubtful that index linked gilts will protect against inflation expectations rising (if nominal yields rise more than inflation expectations) and that conventional bonds are limited in their ability to act as a safe haven (because yields are so compressed), we currently doubt the defensive characteristics of many of the sectors traditionally believed to behave in such a way.

For example, many of these so called defensive sectors have added to their debt levels over recent years, which makes them more sensitive to economic cycles or, to be precise, interest rate cycles. A related point is to consider what investors are trying to defend against. If it’s a recessionary environment, then defensives might well start to shine. However, economic momentum remains strong and a recession remains unlikely in the short term. Instead, markets look to be getting the bit between their teeth again in terms of the US 10 year Treasury yield breaking sustainably through 3%. If we assume rates continue to trend gently higher, which is our base case, then many defensives will face more of a headwind.

Additionally, some of these sectors face fairly serious sector-specific issues. For example, recent evidence suggests that tobacco companies are struggling to replace the falling demand for their traditional product with substitute vaping products. Philip Morris, the largest listed tobacco company, fell 16% on the day of its results as these concerns came to the fore. If this trend continues, one of the key cornerstones of this sub-sector’s defensiveness, i.e. steady demand growth, will be undermined.

In short, the characteristics of asset classes change over time, as does the environment they operate in (be it regulatory, macro or political), so it seems prudent to resist attempts, however tempting, to permanently categorise financial assets in a certain way.

Investor psychology has been dominated by binary cyclical or defensive trends for over a decade, with investors on the right side of the dynamic being handsomely rewarded. This is one of the reasons why markets feel a little directionless this year, with neither group leading the market higher, as noted above.

However, maybe it’s time to redefine what’s defensive. If we’re looking to defend against rising inflation, then physical assets like mining and oils aren’t a bad place to be within equity. In fact, we do also have some exposure to so called defensive equity sectors, but these tend to be in emerging markets, and so tend to have more of a bias to growth. Meanwhile, in bonds, keeping duration short makes sense in a rate rising environment.”

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